PEAK - FREL: Diversified REIT ETF Generating Strong Long-Term Returns

Summary

• Despite a low yield, FREL has consistently generated high total returns over the long run. These returns are quite sustainable over the long run.
• Investors were waiting for readjustments in real estate values & interest rates, which have significantly been incorporated during the past 2 years.
• Significant portion of FREL’s top holdings (2/3rd of its AUM) performed reasonably well during the past 3 months, as well as over the long run.
• Specialized REITs and industrial REITs are generating above-average returns and are expected to perform much better than other REITs.

~ by Snehasish Chaudhuri, MBA (Finance)

Fidelity MSCI Real Estate Index ETF ( FREL ) is an ETF that invests primarily in real estate investment trusts (REITs) in the U.S. stock market. The fund benchmarks itself against the MSCI USA IMI Real Estate Index. It invests in various types of REITs, but unfortunately has relatively high exposure to cyclical REIT sub-sectors such as retail REITs, office REITs, and healthcare REITs. FREL is currently trading at $26.84, almost at par with its net asset value. The fund has an extremely low expense Ratio of 0.08 percent.

Although a series of interest rate hikes severely impacted the real estate sector in the past one year, I have a feeling that such impacts have already been accounted for by the market. Otherwise, FREL generates a decent yield between 3 to 4.3 percent, and has generated strong total returns over the long run. Average annual yield during the past 8 years stood at 3.7 percent, and annual average total return during 2016 and 2021 stood at 12.75 percent. Therefore, this is a good fund to own especially for long-term investors seeking decent current income and strong capital appreciation.

Growth Prospects of Various Segments of Real Estate Investment Trusts

In a scenario of rising inflation and interest rate hikes, REITs are generally considered good bets. However, I believe that investors need to be selective regarding the kind of properties those REITs possess. REITs which are less impacted by recession and in which tenants sign long-term leases, like industrial REITs, Data Center REITs, healthcare REITs and infrastructure REITs. Industrial REITs are a type of REITs that owns, manages, and leases industrial properties, either for setting up factories, warehouses, distribution centers, or e-commerce facilities. These REITs install infrastructures or purchase industrial buildings or acquire land to set up industrial parks on those.

During my last coverage I discussed the growth potential of industrial and infrastructure REITs. Guaranteed incomes and time taken to create such specialized infrastructures, make industrial REITs attractive to investors. The growth of e-commerce businesses largely benefited the industrial REITs over the past decade. With the growing trend of online shopping, e-commerce companies are aggressively setting up fulfilment centers and warehouses near metropolitan areas. There is a demand-supply mismatch for storage and logistics services, and thus it will be beneficial for REITs if they invest in strategic REITs, such as telecommunication towers, self-storage, warehouses, data centers, etc. Office REITs, Retail REITs, Hospitality REITs and Residential REITs, on the other hand, have failed to generate significant growth.

Composition, Performance of Fidelity MSCI Real Estate Index ETF’s Portfolio

FREL’s top 25 holdings account for almost two-third of its $1.54 billion AUM. Half of these companies are industrial and specialized REITs, such as world’s largest private owner of timberlands - Weyerhaeuser Company ( WY ); data centers - Equinix, Inc. ( EQIX ) and Digital Realty Trust, Inc. ( DLR ); market leading operator of gaming facilities - VICI Properties Inc. ( VICI ); owner of self-storage facilities - Extra Space Storage Inc. ( EXR ) and Public Storage ( PSA ); leading players in logistics based real estate properties - Prologis, Inc. ( PLD ), and W. P. Carey Inc. ( WPC ); global leader for storage and information management services - Iron Mountain Incorporated ( IRM ); communication towers and infrastructure operators - American Tower Corporation ( AMT ), SBA Communications Corporation ( SBAC ), and Crown Castle Inc. ( CCI ).

Stocks of industrial REITs and specialized REITs have been the best performing ones, both during the short run and the long run. Out of the 12 specialized REITs listed above, barring DLR and WY, all other REITs had a price growth in excess of 33 percent during the past 5 years, that tantamount to around 6 percent compounded annual growth rate ((CAGR)). This is quite impressive because the performance of the broader market was extremely poor during the past two years. Again, during the immediate short run, i.e., during the past three months, barring EXR and PSA, all other stocks registered a growth in their price. The largest three healthcare REITs, namely Welltower Inc. ( WELL ), Healthpeak Properties, Inc. ( PEAK ) and Ventas, Inc. ( VTR ) are also among FREL’s top 25 investments. Although, price performance of these healthcare REITs was not as impressive as the industrial REITs and specialized REITs, they were not disappointing, either.

Significant investments are also made in residential REITs like Equity Residential ( EQR ), Alexandria Real Estate Equities, Inc. ( ARE ), AvalonBay Communities, Inc. ( AVB ), Mid-America Apartment Communities, Inc. ( MAA ), Invitation Homes Inc. ( INVH ), Sun Communities, Inc. ( SUI ), Essex Property Trust, Inc. ( ESS ), etc. Two retail REITs - Simon Property Group, Inc. ( SPG ), and Realty Income Corporation ( O ) - also constitute part of Fidelity MSCI Real Estate Index ETF’s portfolio, which is composed of 160 stocks. Only SPG, SUI, and O generated double digit price growth during the past three months, while MAA, SUI, and INVH registered a price growth in excess of 33 percent during the past 5 years. We cannot treat the price performance of FREL’s residential REITs and retail REITs as impressive. However, FREL’s overall performance was quite good over the long run, as well as during the immediate short run.

Fidelity MSCI Real Estate Index ETF Seems to Have Good Days Ahead

Fidelity MSCI Real Estate Index ETF has exposures in strong growth sub-sectors such as infrastructure REITs and industrial REITs that will benefit from several important secular trends in the next few years. FREL is dominated by large-cap REITs, which are in a position to acquire properties at a cheap rate. Higher interest rate regime could make things more challenging for such REITs on account of higher borrowing costs, but these REITs have relatively lower leverage. I also think that financial or inflation risks are overestimated and in the coming years, these REITs will perform much better and have more financial stability.

During my last coverage in June 2022, I was not optimistic about this REIT fund. I found that since FREL reshuffled its portfolio almost three years back, certain uncontrollable factors like, pandemic, inflation, and looming recession impacted this fund and REITs significantly. Only industrial REITs were able to grow between June 2021 and June 2022, and in case the economy went into recession, only industrial REITs were expected to grow. Unfortunately, Fidelity MSCI Real Estate Index ETF didn’t invest heavily in industrial REITs at that point of time, and instead invested in residential REITs and Office REITs.

Investment Thesis

Investors have already been quite conservative and it's time that they come out of fears and invest in real assets, which otherwise always have an evergreen investment option. Despite a low yield, Fidelity MSCI Real Estate Index ETF has consistently generated high total returns over the long run. In my opinion, investors were waiting for some readjustments in real estate values and interest rates, which already took place during the past two years. I believe such opportunities don't arise too often, and there lies a strong possibility that these REITs start attracting buyer interest.

Since FREL’s investors rely on its strong total return, its sustainability is of primary concern to them. I believe these returns are quite sustainable, primarily for two reasons - a) significant portion of its top holdings performed reasonably well during the past three months, as well as over the long run, b) Specialized REITs and industrial REITs are generating above-average returns and are expected to perform much better than other REITs. This fund thus will be suitable for both income seeking investors and growth seeking investors. Thus, I am quite bullish about the Fidelity MSCI Real Estate Index ETF.

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